DAVID J. WILLIS ATTORNEY
Copyright © 2016. All rights reserved worldwide.
LEASE-PURCHASES IN TEXAS REAL ESTATE
by David J. Willis, J.D., LL.M.
Lease-purchases have always been a favorite tool of residential real estate investors. They are one of the “Big Three” – alongside contracts for deed and lease-options – all of which are creative devices for getting less than fully-qualified buyers into a home. These contracts have been traditionally popular in Texas for two reasons: first, it was easy to get tenant/buyers into the home by offering a low down payment; and second, it was easy for sellers to evict them through the forcible detainer process if they defaulted (and still keep the down payment).
In a typical lease-purchase (or “rent to own”), a portion of each monthly rent payment is (allegedly) set aside and credited toward the tenant/buyer’s down payment. It is common (but not universal) for a lease-purchase to provide that after a certain amount is paid in, the tenant is able either (1) to convert the transaction from a lease to an owner-financed sales transaction in which the tenant gets a warranty deed and gives back a note and deed of trust to the seller; or (2) the seller agrees that the tenant/buyer may show the accumulated down payment on a loan application to a third-party lender and thereby qualify for take-out financing.
Lease-purchases, lease-options, and contracts for deed present serious burdens and risks to sellers under Texas Property Code 5.061 et seq. relating to “executory contracts” – i.e., contracts that remain essentially unfinished for a period of longer than 180 days. Sec. 5.061 provides that numerous initial and ongoing requirements must be observed if an executory contract is going to be properly implemented, and the burden (as well as all the risk of violation) is entirely on the seller to meet these. More on these requirement and penalties below.
The Dark History of Executory Contracts
In the past, unscrupulous sellers abused executory contracts by disregarding the buyer’s equitable rights and misrepresenting to Justices of the Peace that such buyers were ordinary tenants subject to ordinary leases (untrue, since the buyers have equitable rights). Sellers were then able to obtain evictions for minor or technical defaults, often confiscating large down payments in the process. The seller was then free to move on to his next victim and obtain another down payment. The legislature rightly acted to stop such abuse.
What exactly is an "Executory Contract"
An executory contract is any transaction that defers some action by either party that pertains to ownership or possession of real property into the future. Think of it this way: an “executed” contract is one that is fully performed today. It is done, finished. An “executory” contract, on the other hand, leaves something dangling. Usually the dangling item is the most important item of all, namely, who owns title to the property while the contract is pending and when does the buyer get the deed?
A case from the Texarkana court of appeals provides a good definition of an executory contract: “In a typical real estate contract, the seller and purchaser mutually agree to complete payment and title transfer on a date certain, the closing date, at which time the purchaser generally obtains both title and possession. By contrast, in an executory contract, the purchaser is usually given immediate possession, but is required to satisfy numerous obligations over an extended period of time before the seller has an obligation to transfer actual title.” Bryant v. Cady, 445 S.W.3d 815, 822-23, (Tex.App.—Texarkana 2014, no pet.).
A seller improperly engaging in an executory contract incurs not only penalties under the Property Code (e.g., the return by the seller of all payments made by the buyer, including the down payment and monthly payments) but also liability under the Deceptive Trade Practices – Consumer Protection Act (“DTPA”) which can involve treble damages plus attorney’s fees. Even in minor transactions, small numbers can turn into big ones as a result. Note that the Property Code includes no seller defenses – even if the whole arrangement was the buyer’s idea in the first place.
Does the name of the document matter?
Because of the burdensome requirements and penalties of Prop. Code Sec. 5.061, a landlord/seller may be tempted to re-write a traditional lease-purchase in an attempt to call it something else or make it appear as if it is something else. The important point to remember is this: if the agreement is, in substance, an executory contract, then Sec. 5.061 applies – regardless of the title or wording of the document. Judges tend to look to substance over form (the “quacks like a duck” rule).
A complication that occurs with many lease-purchases (aside from the obvious fact that they are executory contracts) is that they may provide that once a sufficient down payment is paid in the tenant/buyer will have an option to purchase the property at a certain price. Result? The lease-purchase has become tangled up with a lease-option – and becomes become a hybrid “lease-purchase-option.”
What if the lease-purchase provides that payments will continue over a number of years until the property is paid for? Then it may not be a lease-purchase at all. It may an old fashioned contract for deed.
Two points are worth noting. The first is that each of these devices – lease-purchases, lease-options, and contracts for deed – can, if only slightly modified, become hybridized with something else, sinking the transaction deeper into the executory contract hole. The second point is that regardless of the ultimate form such hybrid contracts take, they remain executory contracts for purposes of the rules and penalties of Prop. Code Sec. 5.061 et seq. See our companion article Executory Contracts in Texas.
Executory Contracts: Statutory Requirements
Make no mistake, one can still do a transaction by means of an executory contract – but many burdensome requirements now exist that did not apply before the 2005 revisions to the Property Code. Sections 5.069 and 5.070 contain a number of these requirements, which must be met before the executory contract is signed by the purchaser:
5.069(a) (1) requires that the seller provide the purchaser with a survey which is no older than a year, or a current plat.
Cancellation and Refund
5.069(a)(2) requires that the seller provide the purchaser with copies of liens, restrictive covenants, and easements affecting the property.
5.069(a)(3) requires that a “Seller’s Disclosure of Property Condition” be provided by the seller.
5.069(b) states that if the property is not located in a recorded subdivision, then the seller is required to provide a separate disclosure form stating utilities may not be available to the property until the subdivision is recorded.
5.069(c) pertains to advertising the availability of an executory contract. It requires that the advertisement disclose information regarding the availability of water, sewer, and electric service.
5.070(a)(1) requires the seller to provide the purchaser with a tax certificate from the collector for each taxing unit that collects taxes due on the property.
5.070(a)(2) requires the seller to provide the purchaser with a copy of any insurance policy, binder, or evidence that indicates the name of the insurer and insured; a description of the insured property; and the policy amount.
What happens if the foregoing requirements are not met? Firstly, failure to do so is defined as “false, misleading, or deceptive act or practice” under the DTPA (Sec. 17.46, Texas Business & Commerce Code); secondly, the purchaser is entitled under Prop. Code Sec. 5.069(d)(2) to “cancel and rescind the executory contract and receive a full refund of all payments made to the seller.” That would include any down payment plus all monthly payments that have been made to date.
Note that Prop. Code Sec. 5.074(a) entitles a purchaser to cancel an executory contract for any reason within 14 days of signing, even if all of the statutory requirements have been met.
Financial Disclosure Required
An additional pre-closing requirement is imposed by Prop. Code Sec. 5.071, which requires that the seller provide a thorough RESPA-like disclosure of the financial terms of the transaction, including the interest rate, amount of interest charged for the term of the contract, the total amount of principal and interest to be paid, and the non-existence of a pre-payment penalty. There is some slight relief under this section in that its violation is not defined as malfeasance under the DTPA.
The 7 Day Letter
Another, related pre-closing requirement is contained in Prop. Code Sec. 5.016, which states that “A person may not convey an interest in or enter into a contract to convey an interest in residential real property that will be encumbered by a recorded lien” without giving a 7 day notice to both the lender and the purchaser. The section sets out the required content of this notice, which is quite technical. It should be observed, however, that this odd statute provides no real penalties other than to allow the purchaser to back out of the transaction prior to closing if the 7 day notice was not given. Compliance with Sec. 5.016 is therefore widely ignored with impunity. Expect the legislature to revisit this issue in future sessions.
Punitive Fees and Clauses
Sec. 5.073 prohibits these. Excessive late fees are banned, as a pre-payment penalties and any clause that “prohibits the purchaser from pledging the purchaser’s interest in the property as security to obtain a loan or place improvements. . . .”
In the past, executory contracts were not required to be recorded in the real property records. No longer. Prop. Code Sec. 5.076 states that “the seller shall record the executory contract, including the attached disclosure statement . . . on or before the 30th day after the date the contract is executed. Additionally, any instrument that “terminates the contract” must also be recorded.
Annual Accounting Statement
Prop. Code Sec. 5.077 requires that the seller in an executory contract provide an annual accounting statement every January, which must include the amounts paid, the remaining amount owed, the number of payments remaining, the amount paid in taxes, the amount paid for insurance, an accounting for any insurance monies paid by the insurer, and a copy of the current insurance policy.
Buyer’s Right to Convert to a Deed
The buyer has an absolute right “at any time and without paying penalties or charges of any kind” to convert an executory contract to “recorded, legal title” under Prop. Code Sec. 5.081. The seller has no choice in the matter so long as the buyer tenders the balance owed under the contract. While this right is not required to be stated in the contract, it must be available.
Buyer’s Rights upon Default
It is not permissible to simply evict a buyer under an executory contract if there is a default. Prop. Code Sections 5.063 and 5.064 specify the content of a notice of default and opportunity to cure, which must be followed to the letter if it is to be valid. In other words, the typical “3 day vacate letter” involved in evictions is not sufficient. The buyer is allowed 30 days unconditional right to cure the default.
However, if the buyer has paid in 40% or more of the purchase price, or has made the equivalent of 48 or more monthly payments, then a 60 day notice is required and, if the default is not cured, then a traditional foreclosure (not an eviction) must be used if the seller wishes to regain possession and title (Prop. Code Sec. 5.066). Sellers may take some consolation in the fact that Texas has a highly expedited non-judicial foreclosure process (41 days minimum) that can often be completed more quickly than a contested eviction.
Prohibition of Forfeitures
Section 5.073(a)(4) prohibits a forfeiture of a buyer’s down payment or option fee if a monthly payment is late. This is an important change, because it codifies what judges and juries have been telling lawyers for quite some time. They hate forfeitures. The trend in the law is to view any substantial forfeiture as unreasonable and unconscionable, whether within the context of an executory contract or not, if it results in a buyer losing either a large down payment or the home itself.
Right of First Refusal (ROFR)
Is a ROFR along with a lease a way out? Yes, but caution is required. A ROFR requires the seller, when and if he or she decides to sell, to first offer the property to the buyer. ROFR’s do not specify a price. Depending on how the ROFR is worded, the seller may be required to first negotiate a specific deal with a third-party buyer and then freeze that transaction momentarily while the holder of the ROFR is given a chance, for a limited time, to buy the property at the same price and terms. Alternatively, the price may be determined by fair market value at the time of sale. Careful: As soon as the sellers includes a specific price, it is likely that the ROFR will be transformed into an option, and one again falls within the definition of an executory contract. ROFRs are therefore not an effective substitute for an investor seller who wants to pre-set an above-market price in order to lock in a long-term profit.
See our companion web article entitled Rights of First Refusal in Texas.
Statute of Frauds Applies
All preferential rights to real estate, including lease purchases and lease options, must be express (not implied) and be in writing in order to comply with the statute of frauds. Provisions of the Statute of Frauds applicable to real estate are found in the Business & Commerce Code sections 26.01 and 26.02(b): “[A] contract for the sale of real estate is not enforceable unless the promise or agreement, or a memorandum of it, is (1) in writing; and (2) signed by the person to be charged with the promise or agreement. . . .”
There is another statute that is applicable: Property Code section 5.021, sometimes referred to as the “Statute of Conveyances,” which states: “A conveyance of an estate of inheritance, a freehold, or an estate for more than one year, in land and tenements, must be in writing and must be subscribed and delivered by the conveyor or by the conveyor's agent authorized in writing.”
Beware of Seminar Forms
Be cautious in the use of lease-option forms (or any other forms) from “guru” seminars or obtained off the internet. These forms are suspect since they may not be designed specifically for Texas. They can now get an investor in real trouble. If you have such forms entitled Purchase Option Agreement, Option Cancellation and Release Agreement, Option to Purchase Real Estate, Performance Mortgage to Secure Option, Secured Reverse Assignment Agreement, Slick Tricks to Get What I Want Without Telling Anyone What I’m Doing, and the like, they are toxic waste. One can call a cat a dog but that does not change the nature of the beast. Courts look to substance over form. And remember, courts do not like investors. Moreover, a judge and jury will likely be angry with a seller who tries to pull a fast one with overly-clever verbiage – and more inclined to consider a finding of fraud.
Residential lease-purchases for longer than 180 days are no longer a feasible strategy for investors because of the multitude of requirements and the potential liability for doing them improperly. There is really no way to use a stacking technique here, as is at least theoretically possible in the case of lease-options. Add the fact that the Property Code declares open season on the investor/seller whenever a tenant/buyer becomes disgruntled with an executory contract, and there are more reasons to avoid lease-purchases than there are to do them—especially since loss of an executory contract lawsuit could present an extinction event for a small investor. So sensible investors avoid them. Most real estate lawyers will not do lease-purchases at all, since failure to comply with even the smallest requirement may trigger significant liability for the attorney preparing and filing the various disclosures and documents.
Information in this article is proved for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is retained and expressly retained in writing to do so.
Copyright © 2016 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com